As of this writing, the S&P 500 has gone 1,302 days without a correction of 10% or greater, the second longest run since World War II. As far as the untrained eye can see, risk appears to have disappeared from markets. The performance of the S&P 500 seems to dominate investors’ perception of prevailing risk in the market, despite explosive risk events in certain other asset classes – May and June 2013 saw the worst bond market rout in generations, certain commodity and resource assets lost more than half their value in 2014, and on October 15th 2014, 10-year Treasury volatility experienced a 7 standard deviation move from its intra-day norm (a move that statistically should only happen once every 1.6 billion years. . .no joke). In a diversified portfolio, however, “the market” is far more than just large cap US equities; it is the universe of investible assets. By that measure, risk is alive and well and diversification is more important than ever. This letter serves as a reminder to our clients why diversification is valuable in all market environments, not just those environments that are ostensibly risky. After all, getting you to your goal is the ultimate purpose of our work.
By our measure, risk is what could happen, not what does end up happening. When driving, the absence of an accident tells you nothing about how dangerous a trip could have been. We wear seatbelts and drive defensively because of how risky we know driving can be. The frequency that we drive from point A to point B without an accident, in theory, should not change the utility of a seatbelt and cautious driving. Investors, however, tend to behave differently; the better a market’s returns, the more investors generally want of the best performing asset class (more speed, less seatbelt), even though past returns tell you nothing about what could have happened or could happen in the future. We diversify because we know investing involves risks and that reducing those risks will dramatically improve your odds of reaching your goals:
Diversification reduces the number and magnitude of things that can go wrong. Diversifying over periods of time further amplifies this effect: since 1950, annual total returns for stocks have ranged from 51% to -37%, bonds from 43% to -8%, while a 50/50 blend of the two experienced swings of 32%and -15%. Extend the time horizon to any five-year period and those numbers are +28% / -2%, 23% / -2% and 21% / 1%, respectively:
All else equal, diversification improves risk-adjusted returns and can maximize overall returns over longer periods of time. Your arithmetic return is the simple average of your annual returns: ( -50% + 50% ) / 2 = 0%; your geometric return, on the other hand, reflects the reality of compounding capital over time (losing 50% and gaining 50% is hardly a round trip in the real world: volatility subtracts exponentially from one’s arithmetic returns). Mathematically speaking, by reducing volatility through diversification, while maintaining the same arithmetic return, one also increases the geometric return of a portfolio:
Diversification shortens your recovery time from losses. An all-stock portfolio took more than three years to recover losses after bottoming in March 2009. That’s just to get back to its October 2007 value, a four-and-a-half year round trip. A more diversified portfolio, on the other hand, took fewer than eight months to recover from the bottom, and just more than 2 years to return to its October 2007 peak value. While these differences seem small at first glance, the extra compounding time that diversification afforded the less risky portfolio means that it took roughly a full 6 years for the all-stock portfolio to finally catch up:
Diversification improves investor behavior because it keeps investors safely in their seats, while volatility increases the likelihood that investors will make self-destructive mistakes. A smoother portfolio ride simply allows for clearer, more rational thinking and the disciplined implementation of a plan that, in aggregate, has resulted in better returns when compared to average investor behavior, stereotypically vacillating between fear and greed:
Q1 Market Update
Very little appears cheap in this market and a lot of assets are either fairly valued or downright expensive. US Equities, in particular, are at historic highs and steep valuations “imply investors underestimate the potential for uncertain events to occur,” as one US Treasury analyst recently remarked (the current bull market is now a year and a half longer in duration and approximately 50 percentage points greater in terms of price advance than the average of all bull markets since 1932). Credit spreads (the yield spreads between corporate bonds and US Treasuries) remain exceptionally tight and many fixed income sectors are vulnerable to interest rate volatility, making traditional portfolio hedges like bonds less attractive (i.e. less potentially effective at offsetting other portfolio risks because they could move in tandem). In that context, the prudent way to manage portfolio risk is to actually reduce overall risk, rather than rely too much on negative correlations among asset classes to hold up during bouts of volatility.
Rain portfolios largely reflect our view that divergent monetary policy among major central banks is likely to remain a dominant theme in financial markets for the next few quarters at least. Last year’s dollar rally, the plunge in commodity prices, weakness in emerging markets, and heightened fixed income volatility reflected the leading edge of a new interest rate cycle in the US. Meanwhile, the European Central Bank, Bank of Japan, and other central banks are moving in the opposite direction with additional monetary easing. A number of European countries have gone as far as to effect negative interest rates to prevent outright deflation in the Eurozone.
Low correlation defensive strategies – those that can preserve capital better in the context of volatile interest rate and credit markets – make up a large part of the defensive side of portfolios. That has meant missing out on some of the strong performance of fixed income markets in the past year, but recognizing that the defensive (i.e. capital preservation) part of a portfolio should not be subject to the wild swings that bonds have dished up recently. We have increased exposure to foreign developed country bonds as there remains plenty of downward pressure on interest rates abroad. This exposure is hedged back into US dollars to preserve the ‘flight-to-quality’ benefits that a fixed income allocation can offer as well as avoid damage from the continued appreciation of the dollar.
On the Growth side of portfolios, we have allocated a greater portion of equity exposure to developed foreign markets (and away from US equities) as we expect foreign central bank easing to continue to be supportive of those equity markets. Low Correlation Growth strategies should continue to provide better downside protection than pure equity exposure and should act as a hedge to volatility when (not if) volatility rears its head again. In the context of this lower-risk posture, we expect returns versus risk benchmarks to be somewhat muted, but allowing us to compound returns on a higher base of capital when assets become more fairly priced. We’ve always said we won’t attempt to squeeze every penny of return an asset class has to offer at the expense of risk considerations. We believe reaching for returns in this environment is the surest way to get clients off track from their ultimate goal.